Market-Neutral: It's All About Alpha (not Beta!)

Fiduciaries responsible for pension plan governance
have focused on the management and integrity of the fund. New pressures
are expanding expectations.

by Barry McInerney

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Today, the most prevalent model of pension plan governance targets
a number of key issues:

* Compliance with legislation and regulation and minimum funding
requirements.

* Establishing the asset mix and risk tolerance through the statement
of investment policies and procedures.

* Monitoring of the fund, investment management structure and the
performance of the investment managers in relation to stated objectives.

* As occasions arise, the demands of special situations such as
partial wind-ups, the ownership of surplus and solvency issues.

The focus has been on the fund for good reasons. The performance
of stock markets, the periods of concentration in the Canadian market
and the relative performance of bond versus equity markets have
presented a number of tests in the recent past. In the future, the
prospect of single-digit returns and maturing pension plan membership
will present further challenges in balancing the growth of assets
against liabilities as they come due.

The board of directors is responsible for obligations associated
with the administration of a pension plan and the investment of
its assets. To ensure the required time, knowledge and skill are
brought to pension plan governance, the administrator usually delegates
some or all of these tasks to a pension, benefits and/or investment
committee--the so-called managing fiduciaries. These committees
in turn usually delegate specific administrative and investment
activities to external agents (such as investment managers and custodians),
and internal personnel--the operating fiduciaries.

THE JOINT FORUM
In April of this year, the Joint Forum of Financial Market Regulators
published its Proposed Regulatory Principles for Capital Accumulation
Plans. This proposal followed a 1998 report from the Standing
Senate Committee on Banking, Trade and Commerce which was critical
of the level of disclosure of some DC pension plan offerings and
called for regulatory action.

A stated objective of the proposed regulations for capital accumulation
plans is to provide similar and harmonized regulatory protection
to members. The regulations would cover all types of plans where
the members have a degree of discretion over the investment of their
accounts.

Since a number of sponsors of group registered retirement savings
plans (RRSPs) established these plans in the belief that they would
not attract the weight of regulation of registered pension plans,
adoption of the proposals will certainly affect their governance
and management. If the regulatory requirements are practicable,
this could be a safeguard for some. The direction of case law indicates
that group RRSP sponsors could be subject to legal challenges from
dissatisfied members.

Many sponsors of registered DC plans should review their information
and education policies. In December 1999, William M. Mercer Limited
published a Survey of Defined Contribution Plans, covering
206 DC plans of various types. The survey found that a significantly
high proportion of DC plan sponsors did not provide investment education
to their members.

The regulators are concerned about the range and balance of investment
choices being provided and the adequacy of information about these
investments, in the absence of prospectus disclosure. The Joint
Forum, looking at the U.S.'s Employee Retirement Income Security
Act of 1974, calls for a level of disclosure (including continuous
disclosure) which will enable informed investment decisions.

For enhanced investor protection, the Joint Forum recommends that,
where no prospectus is provided, the sponsor ensure contracts with
a third-party provider or investment manager to allow the plan administrator
or employer to pursue an action on behalf of members for any misrepresentation
about the investments.

The proposal also recommends that sponsors communicate a description
of the types of fees that may be charged to members' accounts and
information on the annual operating expenses of each designated
investment alternative.

RISING EXPECTATIONS OF DB SPONSORS
In the last half of the 1990s, the Office of the Superintendent
of Financial Institutions (OSFI) issued a series of papers on a
wide range of matters that may be considered related to pension
plan governance. Following that, OSFI, along with the Association
of Canadian Pension Management and the Pension Investment Association
of Canada, published the paper and questionnaire, "Pension
Plan Governance and Self-assessment," which pension plans under
federal jurisdiction will be required to complete. If pension plan
sponsors do not clearly demonstrate that they are fulfilling their
responsibilities themselves, the regulators may step in with more
rules.

A certain degree of the interest in DB governance stemmed from
the spotlight on corporate governance in general, and developments
in a number of countries. In Canada, a landmark was the 1994 publication
of the Dey Report, Where were the directors? The most recent
successor of Dey is the Interim Report of the Joint Committee on
Corporate Governance, Beyond Compliance: Building a Governance
Culture, published in March 2001. That report raises the possibility
of a new governance responsibility for pension plans: as institutional
investors are they in any way responsible for improving the corporate
governance of those companies in which they invest?

To deal with current and emerging governance demands, boards of
directors and pension committees may find it useful to set a framework
within which to make and monitor decisions. The framework can be
one of three levels of pension plan governance:

1. The core model of legislative compliance, with the emphasis
on the fund. 2. A model that looks at the whole plan, and focuses on integrated
risk management and cost-effectiveness. 3. A model that manages the whole plan and uses sophisticated
investment strategies that will potentially add value.

* Tasks are delegated down the governance food chain, with reporting
and information flowing back up.

* Tasks are delegated, but not responsibility.

* Due process and evidence of due process will achieve a result
that is appropriate.

Within these governance structure roles, responsibilities and
reporting lines are defined to ensure proper plan administration
is maintained on an ongoing basis. This generally involves:

* developing, authorizing and documenting mandates for the various
fiduciaries and stakeholders;

* keeping committee members and internal delegates up to date on
legislative, regulatory and best practices developments;

* developing, authorizing and documenting procedures to implement
the mandates (such as regular committee meetings); and

* monitoring the overall structure and ongoing activities.

Level one pension plan governance revolves around core fiduciary
responsibilities. For DB plans, this means ensuring there are sufficient
funds to cover the pension promise, filling in the necessary forms,
reporting to the regulators, commissioning actuarial valuations
and maintaining an up-to-date statement of investment policies and
procedures. For DC plans, level one governance activities involve
offering a suitable range of investment options and educating members
on their best use. For DB and DC plan sponsors, it also involves
evaluating the ongoing suitability of the investment managers.

For many pension plan sponsors, the effort and cost associated
with elaborate pension management systems are not justified. A core
fiduciary responsibility of a pension plan sponsor is to keep expenses
down.

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LEVEL TWO GOVERNANCE
Increasingly, DB pension plan sponsors are establishing a governance
model that manages within the context of the whole plan. Not just
the fund, not just compliance, but the whole system.

This model enhances the links between benefit, funding and investment
policies. A governance model that looks at the whole plan takes
into account, for example:

* The extent to which funding and investment risks can be managed
together. This involves linking asset mix policies with risk-based
funding targets. Contributions can then be increased or reduced
as assets fall short or exceed the target. Investment policies would
also be recalibrated to ensure large deficits or unusable surpluses
do not arise.

* The sponsor will periodically re-examine the overall mission
statement of the pension plan. Why was the pension plan set up in
the first place? Is it still doing the job it was intended for?

* In this model, the rationale behind the benefit policy will drive
the strategic communication decisions.

* The examination of administration goes beyond the accuracy of
the benefit calculations, to monitoring the providers, their fees
and the service levels being provided to members.

The whole plan framework facilitates integrated risk management,
which is now becoming an integral part of overall corporate governance.
The Saucier Report on enhancing corporate governance states, "We
recommend that the charter of every board explicitly include the
responsibility to ensure that policies and processes exist to identify
and monitor principal business risks."

The report notes that risks arising from financial operations have
traditionally been the purview of the audit committee. Audit committees,
it is recommended, should also monitor other types of risk: strategic,
operational, leadership, partnership and reputation.

Integrated risk management entails the application of good business
principles to the pension system--good governance and good management.

But financial risk will usually be a central concern. With single-digit
returns and new accounting rules, DB pension plan sponsors are focusing
on investment risks because of the potential impact of investment
volatility on financial statements. The risk mitigation strategies
are fairly straightforward:

* diversification across and within asset classes--and outside
the concentrated Canadian market;

* linking asset strategy to the liability structure;

* balancing growth and value managers;

* developing a hedging policy to mitigate currency risk;

* managing higher foreign currency exposure; and

* adopting rebalancing policies to reduce asset mix drift.

A governance model that looks at the whole plan matches the asset
policy with the structure of the plan liabilities--the profile of
the beneficiaries.

A whole plan governance model will also seek productivity improvements
in administration and cost-effectiveness in spending. Sponsors will
explore various avenues of cost reduction too:

* Securities lending.

* Directed commissions to benefit the fund, rather than the investment
manager. Recaptured commissions should equal 0.02% of a pension
fund.

* Passive management.

* For multinationals sponsoring plans in a number of countries,
a preferred provider arrangement can result in lower fees.

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LEVEL THREE GOVERNANCE
A pension plan sponsor with a large fund and sophisticated resources
is able to move up to a plan governance model that focuses on value
added as well. There are no promises, but in the current investment
environment, some sponsors may want to look at strategies such as
asset mix overlay products, active currency management, global small
cap portfolios, private equity, high yield bonds and market neutral
strategies.

Plan sponsors should make an active policy decision about where
they want to be on the governance spectrum. The mechanics--roles
and responsibilities--will fall out from there.

Barry McInerney leads the investment consulting practice of
William M. Mercer, Incorporated in New York City.